Will The HELOC Reset Wave Impact California Home Values?

The always excellent RealtyTrac produced a very informative “HELOC Resets Report” last month spelling out the coming HELOC reset wave of monthly payment resets on Home Equity Lines Of Credit taken out during the period from 2005-2008. California leads the nation with the most HELOCs resetting, which is not a surprise to most real estate watchers.

For those unfamiliar with HELOCs taken out during the 2005-2008 period, below is a little information about HELOCs and my experiences with the banks originating these loans during Housing Bubble 1.0.

HELOCs are typically bank portfolio loan products, meaning they stay on the books and aren’t sold off to be securitized the way first mortgages are sold immediately after origination. Most HELOCs are in second position behind a larger first mortgage.

During the 2005-2008 period, where home prices peaked and started to decline in early 2007, we saw all kinds of HELOCs being used for both purchases and refinances. It was pretty standard for a bank to lend up to 95-100% Combined Loan-To-Value (CLTV) without any income documentation and without an appraisal. Banks typically would run a homeowner’s credit report in the bank branch and run an Automated Valuation Model (AVM) to determine value.  No tax returns, pay stubs, asset statements required. Nor was a physical appraisal necessary. Several banks, like Washington Mutual and Bank of America, didn’t even run a title report. It was pretty easy to get a HELOC as long as a homeowner had a 720 FICO score and a beating pulse.

What struck me as odd during the years of 2007-2008, was how the bank’s AVM continued to spit out wildly inflated home values based upon the last 6-12 months of sales even though sales prices were noticeably declining and overpriced homes were lingering on the market for 10-12 months without offers. The benefit for the banks in having a computer system looking backward at sales prices even though the market had clearly begun it’s decline was that it allowed the bank to continue offering ever larger loan amounts against over-valued homes, which temporarily boosted profits and commissions/income for bankers whose income was tied to loan volume.

For an example of a ridiculous HELOC from the period, a friend of mine in Portland bought a new construction home in December 2007 for $525,000, putting 20% down and getting a $417,000 first mortgage. He wanted to get a small HELOC of $30,000 to complete the backyard in the spring of 2008. I put him in contact with a loan officer I knew at Bank of America. BofA’s AVM valued his home at $675,000 and offered him a $258,000 HELOC. What!  He just paid $525,000 for the home and their AVM spit out a $675,000 valuation just three weeks after he closed on the purchase. How could that be? My friend only took a $50,000 HELOC since he didn’t need all the extra money. His CLTV after the HELOC was 89%. Had he taken the full $258,000 offer, he would have had a 129% CLTV.

I had another friend in Carlsbad who bought a house for $500,000, taking out a $400,000 conventional mortgage. One month later, he went to BofA to get a small HELOC and was offered $300,000! That was $200,000 more than what he had just paid for his home and effectively 140% CLTV. This friend, who was also in the lending business, took the full $300,000 because he realized that he could use the cheap money from BofA to buy and sell foreclosures that were starting to appear all over San Diego County. And yes, he still has the $300,000 HELOC and continues to use it as cheap money to flip homes.

My guess is that tens of thousands of homeowners in California went into their bank looking for a small HELOC of $50,000 and walked out with a massive $250,000 HELOC that instantly put their home drastically underwater. Some were sophisticated when it came to real estate and could use the money like my friend in Carlsbad did to flip properties whereas others just took the money because it was there and they figured they could buy a bunch of trivial things with it or install a pool with flat-screen TVs at each end (I saw this once on an appraisal – so ridiculous!).

Which brings us to the present where many of these HELOCs originated in 2005-2008 against wildly inflated home values are reaching the end of the 10-year interest-only period and will be resetting at a 20-year fully amortized payment (principal and interest) schedule.  This 10 year I/O with a 30 year repayment period was the norm for HELOCs of the period.

Here’s the key part of the RealtyTrac report pertaining to the situation in California:

“Homes purchased or refinanced near the peak of the housing bubble between 2005 and 2008 are much more likely to still be underwater despite the strong recovery in home prices over the last three years,” said Daren Blomquist, vice president at RealtyTrac. “Furthermore, many homeowners with HELOCs who have positive equity likely already refinanced to mitigate the payment shock from a resetting HELOC – an option not readily available for homeowners still underwater.

“While these underwater homeowners experiencing payment shock from resetting HELOCs are at higher risk for default, the good news is that we’ve already seen a large wave of more than 700,000 resetting HELOCs in 2014 without a corresponding wave of defaults,” Blomquist noted. “The bad news is that a much lower 40 percent of those 2014 HELOC resets were on seriously underwater homes. We are entering a period of higher risk over the next four years when it comes to resetting bubble-era HELOCs — especially given slowing home price appreciation that offers underwater homeowners less hope of recovering their equity in the short term.”

States with most HELOC resets are California, Florida, Illinois, Texas and New Jersey

With 645,872 HELOCs scheduled to reset over the next four years, California led the way among the states in terms of sheer volume of resetting HELOCs. A total of 423,706 (66 percent) of those resetting HELOCs in California are on homes still seriously underwater, and the average monthly payment increase on HELOCs resetting in California over the next four years is $215.

California has 423,706 HELOCs resetting on underwater homes. That’s a lot! Many homeowners won’t be able to afford the payment increase and will realize that they need to get out from under the debt burden by doing a short sale or letting the house go through foreclosure. However, there will be many people who would like to walk away from their home and their mortgage payments, but due to one reason or another (no hardship, can afford the payment, need to keep security clearance for work, etc), they won’t be able to escape, so they’ll stick it out and continue to make the payments.

My guess is that since the vast majority of HELOCs are on the books of the banks rather than securitized, sold to investors, and then serviced by the banks the way that most first mortgages are, is that the banks will modify the terms, lowering the interest rates and extending out the interest-only period for an additional 2-5 years. This form of “extend and pretend” model has been working quite well for the banks and has kept thousands of potentially distressed properties from hitting the market over the past five years, which has played a role in reducing inventory and driving up prices back to Housing Bubble 1.0 territory. At this point, the banks have figured out the system that benefits them the best and they’ll continue pursuing these same “extend and pretend” strategies, slowly dripping distressed properties out onto the market while being cautious not to flood the market with too much supply. The banks facing this coming wave of resets will probably find a way to successfully mitigate the threat of massive losses against their loan portfolios.